1. Using Fiscal Policy

2. Chapter 15: Using Fiscal Policy
KEY CONCEPT
Fiscal policy uses taxes and government spending in an effort to smooth out the peaks and troughs of the business cycle.
WHY THE CONCEPT MATTERS
During the 20th century, periods of rampant inflation and economic depression caused great hardship for millions of people in different parts of the world. The federal government uses a combination of spending and taxation to reduce the impact of economic extremes.

3. What Is Fiscal Policy? Fiscal Policy Tools KEY CONCEPTS
Fiscal—refers to government revenue, spending, and debt
Fiscal policy—government’s use of taxes, spending to affect economy
Expansionary fiscal policy—raises aggregate demand, stimulates economy
Contractionary fiscal policy—reduces aggregate demand, slows economy
Federal government’s tools to influence economy: taxation, spending

4. Fiscal Policy Tools Discretionary Fiscal Policy
Discretionary fiscal policy—actions government takes to stabilize the economy
involve choices government makes about taxes or spending
Congress must enact legislation for policies to be implemented

5. Fiscal Policy Tools Automatic Stabilizers
Automatic stabilizers—fiscal policy features that work automatically
control aggregate demand in expansionary or contractionary manner
Public transfer payment programs and progressive income taxes
increase incomes and reduce impact of a recession
reduce extra income entering economy, slow growth, check inflation

6. The Purpose of Fiscal Policy
KEY CONCEPTS
Expansionary fiscal policy designed to help a weak economy grow
Contractionary fiscal policy used to slow down a growing economy
purpose is to control inflation

7. The Purpose of Fiscal Policy
Policy 1: Expansionary Fiscal Policy
Expansionary policy increases aggregate demand so economy can grow
Increased spending on public projects done by hiring private firms
jobs created; workers spend on goods and services
Lower personal, corporate income taxes leaves more money available
increase in demand for products, saving, capital and labor investment

8. The Purpose of Fiscal Policy
Policy 2: Contractionary Fiscal Policy
Too rapid economic growth leads to demand-pull inflation
Spending cuts mean less income for private firms working for government
aggregate demand drops; production drops; inflation is controlled
Higher taxes reduce disposable income
decreases consumer spending, production; workers laid off; prices drop

9. Limitations of Fiscal Policy
KEY CONCEPTS
Fiscal policy intended to
reduce economic slowdowns that result in unemployment
curb inflation
Has significant limitations

10. Limitations of Fiscal Policy
Limitation 1: Policy Lags
Fiscal policy lags behind conditions it is meant to address
May take time to identify problem and to get Congress to act
Implementing policy change takes time
tax changes can take effect faster than new spending programs

11. Limitations of Fiscal Policy
Limitation 2: Timing Issues
Fiscal policy meant to smooth out peaks and troughs of business cycle
If timing is good, fluctuations in the business cycle are less severe
If timing is bad, policy can make matters worse. Example:
if moving out of recession, expansionary policy can bring on inflation

12. Limitations of Fiscal Policy
Limitation 3: Rational Expectations Theory
Rational expectations theory—people anticipate that changes in fiscal policy will have certain outcomes
take actions to protect themselves against outcomes
May expect expansionary policy to increase demand and raise prices
so buy more to stay ahead of inflation, thus causing more inflation

13. Limitations of Fiscal Policy
Limitation 4: Political Issues
Political considerations, especially chance for reelection, influence policy
Council of Economic Advisers—group of advisors to president
President or Congress may not follow their advice
particular issue for House where all tax bills originate

14. Limitations of Fiscal Policy
Limitation 5: Regional Issues
Not all parts of the country may have same economic conditions
One state or region may have recession while another has inflation
One broad policy for entire nation may not be appropriate

15. Reviewing Key Concepts
Use each of the terms below in a sentence that illustrates the meaning of the term:
expansionary fiscal policy
discretionary fiscal policy
rational expectations theory

16. Demand-Side Economics
Demand-Side and Supply-Side Policies
Demand-Side Economics
KEY CONCEPTS
Until Great Depression, government did little to influence economy
persistent unemployment, low production changed many economists’ minds
John Maynard Keynes proposed Keynesian economics:
idea that during recession government should stimulate aggregate demand
basis of demand-side fiscal policy—policy to stimulate aggregate demand

17. Demand-Side Economics
Keynesian Theory
Changes in aggregate demand affect business cycle: GDP = C+I+G+F
GDP = consumer (C), investment (I), government goods (G), net exports (F)
exports small role in the economy; consumer, government spending stable
Keynes believed investment caused fluctuations in the economy
spending multiplier effect—a spending change results in larger GDP change

18. John Maynard Keynes: Architect of Demand-Side Policy
Using Government Action to Stimulate Demand
Keynes: lower aggregate demand meant layoffs, less aggregate demand
Began field of macroeconomics and revolutionized economic thinking:
aggregate demand is sum of investment, consumer and government spending
only active government action can break the patterns in business cycle
government spending to stabilize economy better than balanced budget

19. Government and Demand-Side Policies
KEY CONCEPTS
Discretionary fiscal policy involves making choices about taxation and spending
increase aggregate demand or control inflation
Demand-side policies advocate use of these fiscal policy tools

20. Government and Demand-Side Policies
The Role of Government
Depression economy stable, but high unemployment, little aggregate demand
Keynes argued for government spending to create jobs, increase income
also lower taxes to encourage consumer spending, business investment
During inflation Keynes favored decreased spending, raised taxes

21. Government and Demand-Side Policies
Demand-Side Policies—Analysis
Sometimes demand-side policies work; example, World War II production
Difficult to discontinue popular programs after recession
Difficult for politicians to raise taxes during inflationary periods
Demand-side policies ineffective for stagflation
slow economic growth with unemployment and inflation

22. Supply-Side Economics
KEY CONCEPTS
Some economists prefer influencing the economy through supply side
Supply-side fiscal policy—provides incentives to producers
focuses on cutting the cost of production to increase aggregate supply

23. Supply-Side Economics
The Role of Government
Supply-side economists favor cutting individual, corporate taxes
to encourage people to work, save, invest more
reducing highest tax brackets frees income to most likely investors
Favor lower government spending: if need less revenue, can lower taxes
Favor less regulation: cuts production costs, ups aggregate supply

24. Supply-Side Economics
The Laffer Curve
Laffer Curve—shows how tax cuts affect tax revenues, economic growth
Laffer said tax revenues increase as tax rates increase up to a point
Higher taxes discourage working, saving, investing
people find alternatives to income-producing activities
taxable income, revenue drops; aggregate supply falls; economy slows

25. Supply-Side Economics
Supply-Side Policies—Analysis
In 1980s, taxes were reduced but revenue increased
inflation, unemployment fell; economy grew steadily
Some chose to work fewer hours for same income; savings declined
Some economists: success depends on where economy is on Laffer Curve
Others say economy grew from tax cuts plus increased defense spending

26. Reviewing Key Concepts
Explain the relationship between the terms in each of these pairs:
Keynesian economics and demand-side fiscal policy
supply-side fiscal policy and Laffer Curve

27. The Federal Deficit and Debt
Deficits and the National Debt
The Federal Deficit and Debt
KEY CONCEPTS
All levels of government struggle to achieve balanced budget
Budget surplus occurs when government takes in more than it spends
Budget deficit occurs when government spends more than it takes in
Deficit spending—spending more than revenues for specific budget year
National debt—the total amount of money the government owes

28. The Federal Deficit and Debt
Causes of the Deficit
Four main reasons for deficit spending
— national emergencies usually require massive spending beyond normal budget
— building public goods and services is expensive, work takes years
— public projects to stimulate, stabilize weak economy need large sums
— entitlement programs that people depend on are expensive

29. The Federal Deficit and Debt
Raising Money for Deficit Spending
To borrow money, federal government issues bonds through Treasury Department
Savings bonds mature in 20 years; denominations from $25 to $10,000
Treasury bills (T bills) mature in less than one year
Treasury notes mature between 2 and 10 years
Treasury bonds mature in 30 years

30. The National Debt KEY CONCEPTS
Government owes bond holders the amount of the bond plus interest
Also borrows from government trust funds—money held for specific future purpose
trust fund surpluses invested in bonds until programs need the funds
some economists do not think moving funds within government is debt
no burden to current economy because current budget does not pay for it

31. The National Debt The Current Debt
In August 2006, national debt about $8.4 trillion
federal deficits and debt increased during 1980s, 1990s
since 1980s debt has grown faster than inflation—grown in real terms
In 1981, debt was 33 percent of GDP; in 2006 was nearly 68%
in 1981, about 80 percent privately owned; in 2006 less than 60% private

32. The National Debt The Effect of the Debt on the Economy
If government spending stimulates economy, jobs and public goods created
If government outbids private sector, pays higher bond interest rates
crowding-out effect—money leaves private sector, interest rates rise
Constant borrowing increases total interest and taxes to service debt
higher taxes decrease consumer spending and business investment

33. The National Debt Attempts to Control Deficits and Debt
Sharp rise in deficits, debt in 1980s
Officials tried various measures to control deficit spending
Various bills had mixed success; government continues to struggle

34. Reviewing Key Concepts
Explain the differences between the terms in each of these pairs:
budget surplus and budget deficit
national debt and deficit spending
Treasury bills and Treasury bonds

35. Is the Federal Deficit Too Large
Background
Taxpayers ultimately pay the interest on the national debt, which is created by deficit spending by the federal government.
The government uses deficit spending for several reasons, including paying for national emergencies and implementing expansionary fiscal policies during periods of recession.
What’s the Issue
Is the federal deficit too large?
Thinking Economically
Identify the economic cause-and-effect relationships described in Documents A and C.
How does Document B illustrate the challenge facing the Bush administration in its efforts to carry out the plan discussed in Document C?
Do you think the Bush administration shares the concerns about the deficit expressed in Document A? Use information from the documents to explain your answer.